How to Prepare for Fragmentation in the Brazilian Marketplace

Economic indicators suggest that South America's hottest market will soon join the global trend and embrace a multi-market structure with liquidity fragmented across different venues.

After an intense period of transformation and realignment in the Brazilian market, which resulted in a new infrastructure, fee reductions and the introduction of co-location facilities, it looks as if the markets will be stirred up once again.

While the BM&FBOVESPA (BVMF) has been actively pursuing electronic and high frequency trading, the Comissão de Valores Mobiliários (CVM) has commissioned a report to evaluate the efficiency of the Brazilian capital markets and analyze the possibility of listing stocks simultaneously on a stock exchange and on an organized over the counter market.

By law, the CVM has the power to promote the operation of organized markets to serve as liquidity centers and facilitate corporate capitalization, allowing for competition by exchanges like Direct Edge and BATS, who have indicated their intentions to launch Brazilian marketplaces.

Following the significant investments in technology made by the BVMF, the new technology investment will shift to the sell-side if fragmentation comes to Brazil. The model in which brokers use front-office applications supplied by the primary exchange is no longer viable in a multi-market environment, and it is clearly undesirable to have separate terminals replicating these functions for each venue. Instead, brokers will need a single trading platform that provides consolidated data across all venues, and low-latency market gateways with direct connectivity to each one.

The front office will also require smart order routing (SOR) capabilities that can determine best price and identify where available liquidity can be intelligently accessed. As part of the strategy surrounding smart order routing, brokers will require pre-trade analytics demonstrating the potential impact of a trade and post-trade analytics which can summarize the cost of trading an order across the venues.

Latency is also an important factor in automating liquidity capture in a multi-market environment. Brokers cannot depend on a single co-location facility, or on the inter-linkage of the markets to provide order routing for liquidity not on their books. Brokers will either implement multiple co-location facilities or strategically proximity host solutions with direct connections to the markets to gain low-latency market access.

With a fragmented market, the biggest challenge of all will be the demonstration of best execution. Brazilian regulators will surely establish their own definition of best execution. Whether the country will adopt a US-style trade-through approach that focuses on price as the key criteria for determining best execution, or a more European, principles-based model in which best execution is based upon a range of factors, is not yet clear.

The efficient integration of the core functions mentioned above is key. Markets may be fragmenting, but technology cannot: using different core trading technologies loosely grouped together is far from ideal. If too many of the functions involved in electronic trading across multiple markets operate independently, it adds latency, increases the risk of operational inefficiencies and leads to missed trading opportunities and possible compliance issues around best execution.

There will also be changes required in the middle office, but there have been no announcements yet around functions like clearing and settlement, and how they will integrate with a fragmented marketplace. Whether new venues will create their own clearing operations or clear through BVMF's facilities, it will have an impact on the way allocations are managed and on middle office capabilities. Again, the existence of multiple markets suggests that brokers will need to determine whether to establish their own, independent middle office capabilities to handle allocations across multiple venues or purchase a solution from an established technology vendor.

Currently, there is little room for additional venues as there are not enough liquid stocks to justify the investment. Moreover, Brazil has no ATS rules so all new venues have to register as an exchange, which is a long and complex process. But experience from around the world suggests that once fragmentation starts, venue complexity will only increase.

Even if Brazil retains its ban on dark liquidity, the days of trading solely on a primary venue look as if they are coming to an end. Brokers with an eye to the future will have to future-proof their technology solutions, to ensure they have the necessary tools to stay ahead of the ongoing transformation of the Brazilian markets.